Are Subprime Mortgages Returning?

A common reaction might be: it just isn't possible. Could subprime mortgages -- the toxic products the led to the worst financial crisis and subsequent recession in decades -- really be making a comeback, already? After all, it was less than three years ago that they wrecked the economy, as investors panicked and credit frozen due to the huge potential losses they feared subprime borrowers with cause for the financial sector. New reports appear to indicate that the market hasn't learned. Should we worry?

Renewed Demand for Toxic Securities?

First, Matt Wirz and Serena Ng at the Wall Street Journal report that investors are regaining their appetite for subprime. They note that subprime mortgage bonds have doubled in value since their low point of the crisis. Some investors are scooping up the securities again, in the hopes of earning a big return:

They seek the fat yields these subprime mortgage bonds offer, at a time when the Federal Reserve has pushed interest rates on the safer investments to some of the lowest levels ever seen. In addition to subprime bonds, conservative investors are re-entering the market for other so-called nonagency bonds, which means they aren't backed by Fannie Mae or Freddie Mac. These securities yielded close to 20% during the downturn, and are now fetching between 5% and 7%--still well above roughly 3.5% yields on U.S government bonds and 4% on high-quality corporate bonds.

Investors are not really after exposure to newly originated subprime mortgages, at least not according to this report. Instead, they're after the subprime bonds that are already in the marketplace for two reasons. First, the securities were likely very undervalued as distressed assets when the crisis peaked. Those prices were partially a consequence of uncertainty and panic, along with weak fundamentals. Investors will still get a nice discount and high yields -- just not the fire sale prices available a few years ago. Second, the bonds are relatively attractive, because interest rates on debt have been so low for so long. Investors who are looking for yield have little choice but to move further out on the risk spectrum.

And that latter point has an interesting implication. The Federal Reserve has been responsible for keeping rates very low for an extended period. Its policy is driving the desire of investors to acquire more subprime bonds. If higher quality bonds offered better yields, then investors wouldn't need to feed at the subprime trough.

This report does not imply that investors are strongly interested in new privately originated subprime mortgages. If it did, then that would suggest that banks are aggressively pursuing subprime borrowers. They likely aren't. Instead, the deeply discounted inventory of these bonds is being sought.

More Risky Mortgages?

But there's a separate article that suggests borrowers are again able to obtain the same sort of risky mortgages that helped to create the housing bubble. Sarah Riley reports for The Daily:

CAPE CORAL, Fla. -- All it takes is $1 down to buy a brand-new $150,000 home in this foreclosure-wracked community, thanks to two government programs that guarantee loans for buyers who want a house but can't scrape together enough cash to cover closing costs, let alone a standard down payment.

The dollar-and-a-dream offer makes good sense for builder Adams Homes -- it pockets the full purchase price, regardless of whether the cash-strapped buyer continues making payments.

That's because all the risk in this very risky transaction lies with the federal government.

Crazy, you say? A bank certainly would be nuts to extend this type of credit again. But that's not the case here. This article is about Federal Housing Authority loans. They combine a mortgage for 96.5% of the value of a home with a federally insured loan for the remainder that covers down payment and closing costs.

The FHA has been providing these kinds of loans for some time now. They certainly can be very risky, but the problem they may pose is likely benign for two reasons. First, the loans in question are explicitly guaranteed. There's no reason to worry about the moral hazard problems as we saw with Fannie Mae and Freddie Mac. If losses begin to grow too large, then the government agency will have Congress to answer to. Second, these loans are relatively limited. They're reserved for a small segment of the low- to middle-income population. So these mortgages won't inflate a new housing bubble; there just aren't that many being made.

The government will always be in the business of making some risky mortgages. Even the most conservative housing finance policy alternatives out there -- like one from the American Enterprise Institute -- acknowledge that there are political reasons why the government will likely play this role in the mortgage market going forward. Perhaps this risk should be more carefully limited, but taxpayers will always face some explicit loss from these activities.

So some investors are broadening their subprime bond exposure and some risky mortgages are being originated. But considering the circumstances for both of these new trends, it isn't time to panic. Subprime mortgages had been around for decades before the credit crisis. They shouldn't necessarily be forbidden, but treated with prudence to ensure that borrowers have the capacity to repay their loans and that investors appropriately price the risk that they pose.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation.